Jorgenson's Neoclassical Notion Of Investment

Jorgenson has developed a neo classical notion of investment. His notion of investment
behaviour is predestined on the determination of the finest principle stock. His investment
equation has been taken from the profit maximisation notion of the industry.

Postulations

Jorgensen’s notion is based on the following postulations.

The industry functions under perfect competition

There is no ambiguity

There are no amendment rates

There is full employment in the fiscal where prices of labour and doctrine are
perfectly supple

There is a perfect fiscal market which means the industry can take loan or lend
at a specified rate of interest

The manufacturing function associates productivity to the input of labour and principle

Labour and capital are standardised inputs manufacturing a standardised productivity

Inputs are engaged upto a point at which their MPPs parities to their real unit
rates

There are deteriorating returns to level

There is the survival of putty – putty doctrine which means that even after
investment is made, it is instantaneously modified devoid of any rates to a diverse
skill

The price of principle goods parities the rebated value of the rental charges

The industry optimises the present value of its present and anticipated profits
with perfect prudence in relation to all the future values

Tobin’s Q Notion of Investment

Nobel Laureate economist James Tobin has proposed the q notion of investment which links
an industry’s investment choices to variations in the stock market. When an industry
finances its principle for investment by issuing shares in the stock market, its stock
prices replicates the investment choices of the industry. Industry’s investment
choices is based on the following ratio, called Tobin’s q:

q = Market
Value of Principle Stock
Replacement
Rate of Principle

The market value of industry’s principle stock in the numerator is the value
of its principle as indomitable by the stock market. The replacement rate of industry’s
principle in the denominator is the original rate of existing principle stock if it
is acquired at today’s price. Thus Tobin’s q notion describes net investment
by relating the market value of industry’s fiscal assets (the market value of
its shares) to the replacement rate of its real principle (shares).

As per Tobin, net investment would be based on whether q is higher than (q>1) or
less than 1(q<1). If q>1, the market value of the industries equities in the
stock market is greater than the replacement rate of its actual principle, machinery
etc. The industry can purchase more principle and issue additional shares in the stock
market. In this way by selling new equities, the industry can bring in profits and
finance new investment. Conversely, if q<1, the market value of its shares is less
than its replacement rate and the industry will not replace principle (machinery) as
it obsoletes.

Illustration 40

Suppose an industry raises finance for investment by issuing 2 million shares in the
stock market at $20 per share. Currently their market value is $40 per share. If the
replacement rate of the industry’s real principle is $40 millions,

What is the q ratio?

Suppose the market value rises to $80 per share, what is the new q value?

Solution

q = Market
Value of Principle Stock
Replacement
Rate of Principle

q = (1,000,000
shares x $20)
$20,000,000 q = 1

The new q ratio is

q = 1,000,000
shares x $40
20,000,000

q = 40,000,000
20,000,000

q = 2

Now the market value of its shares gives $20,00,000 ($40,000,000 – $20,000,000)
as profit to the industry. The industry raises its principle stock by issuing 500,000
shares at $80 per share. $20 million collected through the sale of 500,000 shares are
utilised for financing new investment by the industry.

This is illustrated in the diagrams below. The diagrams stand for how a hike in Tobin’s
q provokes a hike in the industry’s investment. It depicts that a hike in the
demand for equities hikes their market value which hikes the value of q and investment.
The demand for principle is given by the demand curve D in the panel (1).

The relative value of q is taken as one as the market value of replacement rate of principle
stock is alleged equal. The initial equilibrium is indomitable by the interface of
demand for principle and the accessible contribution of principle stock OK at point
E, which is preset in the short run.

The demand for principle is based chiefly on two factors. (1) The level of prosperity
of the public. The greater is the level of riches the more equities people wish to
have in their wealth portfolio. (2) The real return on other investments such as government
bonds or real estate. A drop in the original interest rate of government bonds would
induce people to invest in equities than in other forms of wealth.

This would hike the demand for principle and hike the market value of principle over
its replacement rate. This means augment in the value of Tobin’s q over unity.
This is denoted as the rightward budge of the demand curve to D1. The new equilibrium
is established at E1 in the long run when the replacement rate rises and equals the
market value of principle. The augment in the value of q to q1 provokes a hike in new
investment to OI, as denoted in the panel (2) of the diagram.

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